I decompose the price-to-book ratio of each stock into two components via a linear projection. The fundamental component is the fitted value based on cash flow variables, and the transitory component is the residual term. In a simple model of signal extraction, both components are positively correlated with the price-to-book ratio, but a higher fundamental component predicts a higher subsequent stock return, whereas a higher fundamental component predicts a lower subsequent stock return. I confirm these predictions in the U.S. stock market. I also find evidence suggesting that the fundamental component predicts stock returns because it captures investors' underreaction to cash flow news, while the transitory component predicts stock returns because it captures return reversal.
Keywords: Value Premium, Discount Rates, the Price-to-Book Ratio.
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